PRINTMarket Update -- In the Markets
February 13, 2008
Amid heightened uncertainty about the economic and financial market outlook, a large number of financial market participants have spent the last several months accumulating significant short positions in credit products. Many investors are using credit default swaps (CDSs) to hedge existing longs, while others are using them to speculate on further deterioration in credit markets. The growing short base has contributed to the continued dramatic widening of credit spreads, and has helped put existing short positions well in the money. Some of the hedges in CDS probably won't be lifted until their owners are ready to sound the all-clear, but a lot of the speculative (naked) shorts, it seems, are beginning to get a little complacent.
And complacency can be very dangerous. In fact, today's credit crisis is the market’s punishment for years of complacency on the long side.
The demand for default protection in the CDS markets has crept up into the highest levels of the credit spectrum. As CDS spreads on riskier credits widened and became more and more expensive to short, speculators and hedgers looked for cheaper things to short. A good illustration of this phenomenon can be seen in the CMBX indexes, which are CDS indexes based off of a representative basket of CMBS bonds.
Due to aggressive loan underwriting in recent years and exceedingly low credit enhancement levels on the lower-rated mezzanine classes of recent vintage CMBS transactions, the lowest parts of the capital structure are indeed quite vulnerable to a downturn in commercial real estate. Loan-to-value ratios on the underlying loans often exceeded 100% on a stressed basis, and some loans were underwritten with assumptions of future rent increases that may be at risk in a slowing economy. A majority of these loans were also structured as non-amortizing interest-only loans, which required no additional equity contribution by the borrower. Once these loans were securitized, the issuers were able to receive investment-grade credit ratings on mezzanine classes with as little as 3% of subordination. Rating agencies, after all, were competing against one another to win issuers' business, and were generally hired by the issuers based upon their willingness to ease subordination requirements (it doesn't take a cynic to see the potential conflict in rating the very entity that is paying your bill).
One can see why investors might be interested in shorting CMBS subs. As the economy slows and commercial real estate markets suffer the effects of the credit crunch, many of these subordinated bonds are likely to experience sharp credit ratings downgrades, with some eventually incurring principal losses or even full write downs.
And in today's market, investors are paying more than $17 per $100 face per year to insure against defaults on the lowest investment-grade rated subordinated bonds off recently issued CMBS deals using credit default swaps on the CMBX series 4 BBB- index. Currently, the average life of the index is just under 10 years, meaning that a buyer of default protection will spend about $170 to insure $100 of principal over the life of the bonds if they all eventually mature (ignoring the opportunity cost of foregone interest on the invested premium). Needless to say, the market is telling us that these subordinated bonds won't mature, but will lose all of their principal sometime in the next few years. To those buying credit protection, it is no longer a matter of if, it is a matter of when. An investor seeking a 10% return on a short position would, at current levels, need all 25 bonds underlying the CMBX index to lose all principal within 4 years.
Even though loan delinquencies are expected to rise dramatically, it's probably worth pointing out that as of January, the deals comprising the CMBX series 4 index had a cumulative loan default rate of just under one tenth of one percent, and zero cumulative losses. Assuming an average workout period of one year on defaulted loans, those default rates are going to have to rise pretty quickly to rack up cumulative losses of 3% within four years. And they may do just that. But the risks of serious credit events diminish significantly further up the capital structure.
Subordination levels on the super-senior tranches of CMBS deals typically run at 30%, a multiple of what the rating agencies require for their highest credit ratings (the average AAA subordination level on bonds included in the CMBX series 4 index is just under 12.5%). With 30% of subordination, the deal could suffer a cumulative default rate of 75% and average loss severities of 40% – well above the norm – before any dollar of principal would be at risk. One can hardly fathom an economic environment that would produce such a high default rate, and as a result, default protection on the AAA slice of the CMBX indices used to cost just a few pennies per $100 of principal per year. But as of this writing, that cost has risen above 2 dollars, or 200 basis points per year, an increase of over 3000% from the lows.
The irony is that if the buyers of AAA protection ever actually need to file a claim on their insurance policy, the insurance provider, i.e. their swap counterparty, may itself no longer be solvent. After all, how likely are commercial banks and brokerage firms to survive the kind of economic catastrophe that would produce 75% default rates on commercial mortgages?
These are not second-lien subprime mortgages, folks. Commercial real estate loans are underwritten based on actual financial statements, rent rolls, and site visits. They often include extra safeguards such as upfront and ongoing reserve accounts, tax escrows, and lender-controlled lockbox accounts. Commercial properties are income producing assets, often with long term in-place revenues and a diversified corporate tenant base. They can continue to produce positive net incomes even when their prices decline, and most markets continue to experience a healthy supply and demand dynamic characterized by positive net absorptions (leased space minus new and vacated space). Meanwhile, loan sponsors (borrowers) are typically large pension funds, publicly traded REITs, high net worth investors, and multi-billion dollar real estate funds that won't miss a mortgage payment due to unexpected car repairs.
75% cumulative defaults? No way. 50%? Nope. 20%? On some of the worst deals? Maybe… Maybe.
Yet still, people are paying more than 200 basis points per year to insure against defaults on super-senior CMBS bonds. Perhaps they're shorting the super-seniors because they're a less expensive short than the subordinate classes. But "expensive" is a relative measure, and some investors would argue that all naked shorts are inherently expensive because they're negative carry - you have to pay out money to keep them on your books. Longs, on the other hand, produce income. In the world of bonds, if you're long and nothing happens, you make money. But if you're short and nothing happens, you lose money.
So what if nothing happens? Or worse – what if monetary and fiscal stimulus kick in, spending increases, and liquidity conditions gradually start to improve?
The dramatic spread widening that has occurred in the credit markets in recent months has been a reflection of increased credit risk owing to a slowing economy, and balance sheet scarcity, or liquidity risk, resulting from a de-levering in the financial system. Those who are shorting super-senior CMBS via CDS in order to hedge against market value declines on their bond portfolios might benefit from a reminder that default insurance doesn't provide any actual payouts for spread widening or rising liquidity premiums. And those who are shorting the market merely to speculate on further increases in the cost of default protection risk getting caught in a classic short-squeeze, because it's a crowded trade and none of them want to get stuck shelling out 200 basis points a year for the next ten years.
Dare we say that credit default swaps are the latest financial market bubble?
No, we don't. But we do advocate buying bonds. Especially super senior CMBS and other high quality structured products that offer huge spreads over Treasuries and virtually no default risk. And if you think spreads will widen further, buy short bonds. The very worst that can happen is the bonds mature, you pocket a few hundred basis points over Treasuries, and you have to reinvest at tighter spreads.
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